Meeting the Income Challenge

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The knock-on effects of low interest rates are wide-ranging. Near-zero returns on bond portfolios impact the income of savers and retirees as well as the withdrawal needs of pension funds and Governments. And low interest rates could result in retirees being forced to save more for longer. Meanwhile, some investors in search of yield will naturally turn to riskier investments such as equities.

Low interest rates also encourage individuals and companies to borrow more, raising the possibility they may encounter difficulty paying back debt should interest rates rise sharply. The subprime mortgage crisis serves as an ominous reminder of the dangers of borrowers over-reaching themselves.

Meanwhile, rising rates usually increase the cost of borrowing for individuals with credit cards, loans and mortgages. This can discourage consumers from taking out loans, resulting in a decline in consumer spending. But savers with deposit accounts stand to benefit from higher interest payments.

The Fed increased rates by a quarter percentage point in December 2015 after a seven-year period in which the central bank held its benchmark federal-funds rate near zero in response to the worst financial crisis since the Great Depression.

The Fed’s December 2015 rate rise represented a vote of confidence in the US economy. The brighter outlook was supported by a low unemployment rate and strong growth numbers. The move was also backed by economists who argued rates needed to rise to stave off excessive consumer borrowing and prevent bubbles emerging in the housing market and other sectors.

The move away from historically low rates brought an end to an extraordinary period of Government intervention. It was also highly symbolic — it signaled that the US economy was back on a firmer footing while at the same time leaving rates at low levels.

When the Fed raised rates it also indicated its intention to enact four further rate increases in 2016. However, the Fed has subsequently pared back its expectations to just two rate rises this year amid heightened global financial uncertainty. At its March’s meeting it left rates unchanged at 0.25%-0.50%. And Fed Chair Janet Yellen recently said the central bank will proceed cautiously with further increases in comments that sent the dollar lower against other currencies.

The Fed’s caution around further rate increases comes as several central banks — including the Bank of Japan, the ECB, Denmark’s National bank, the Swiss National Bank and Sweden’s Riksbank — now experiment with negative interest rates.

In her press conference following the March Federal Open Market Committee announcement, Yellen said the Fed was not considering introducing negative rates. However, US regulators have taken note of the monetary policies pursued by other central banks in other areas. The Fed has toughened up this year’s bank stress tests, for example, by assuming a more adverse economic scenario which factors in the possibility of negative interest rates in the US in a nod to the action taken by other central banks.

The Fed’s decision to raise rates at the end of 2015 also contrasts with the monetary policies pursued by some BRIC countries, with the Reserve Bank of India recently cutting interest rates to their lowest level since 2011 and Brazil keeping rates on hold as it struggles with recession. The divergent monetary policies pursued by central banks around the world is a relatively new phenomenon which could have unintended and unforeseen macroeconomic consequences.

The fixed income arena is especially sensitive to monetary policy decisions, with bond investors often at the mercy of central banks and their monetary moves. A major decision by the Fed can send powerful shockwaves through the whole fixed income market.

A distinction should be made, however, between rising interest rates and a high interest rate environment. The Fed’s marginal rate rise in December merely marked the end of an exceptional period of emergency rates put in place in the aftermath of the Great Recession. Rates remain low today and are a far cry from the situation in 2007 when US interest rates stood at 5.25%. And with the Fed indicating that future monetary policy moves will be small and gradual amid the low inflation environment, the impact of rate increases on income investors may not be as dramatic as feared. Nevertheless, such investors should factor these expected rate increases into their thinking and strategies.

Our research shows that investors expect investment income to account for 9% of their total retirement funding. And amid still ultra-low interest rates and a stock market sell-off at the start of the year, finding investments that provide yield will prove all-important. One option is dividend stocks, which US investors have been flocking to recently.

Emerging market debt is another option for income seekers. While emerging markets may have suffered a prolonged period of underperformance, investors are again looking at the sector amid improved fundamentals. Emerging market bonds, which have recently staged a rally, offer the potential for higher yields than good quality Government or corporate debt as well as diversification benefits.

This paper examines what options are available for income investors in the prevailing low interest rate environment and how investors can guard against — and benefit from — rising interest rates.

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